After some of last weekend's discussion, I wish to continue my war against the finance industry for focusing on the question of "how much money can my money make?" instead of what should be the primary question for financial planning, "how much money does my money need to make, given how much I save and spend?"

Loki,

You ask an excellent question, but if you want to wage war on the financial industry, do a frontal assault, instead of messing around at the peripheries. What is the current, central belief of the financial industry as it targets the acquisition of the assets of retail investors? That such investors can achieve close to market performance by owning the market, which the industry –-conveniently-- will sell to them in a variety of wrapper products. That's the belief that needs to be attacked, because it's a chimera, as can be seen by asking the question: “Which market?”

Now, some background.

In 1996, in an effort to troll for clients, Bowen, Reinhart, and Werba put together are very readable overview of asset-class investing called, “The Prudent Investor's Guide to Beating the Market”. It's regrettable that they used such a misleading title, because, like all Modern Portfolio Theorists and camp-followers, they aren't really talking about beating the market, which they all blithely believe can't be done. Instead, what they do believe is possible is the construction “efficient portfolios” by building on the insights offered by Markowitz in his 1952 paper and as it was subsequently amended or expanded by Sharpe, Fama, French, etc., some of whom are actually worth reading.

The process by which MPT camp-followers get to where they are today is through a series of bootstrapping operations. First, they set up a tripartite, straw-man argument, claiming that three models describe all of investing: the ”stock-picking” model, the “market-timing model”, and the “asset-class” model. Then, by scraping together studies dependant on flawed methodologies, they “prove” that stock pickers have an abysmally poor record of being able to out-perform the market. As a side excursion, they also show that those who attempt to pick stock-pickers fare no better. So, they reject that model. They repeat the same demonstration for market timing, arguing that no one can show proof that it works. And they do an another side excursion and “demolish” technical analysis. What does that leave standing? Only asset-class investing, right? Which depends on being able to pick markets, in particular, markets with low correlations with each other, of which they –-conveniently, in matrix form-- can provide a list.

Here's what I say to them.

“That no one can pick stocks is nonsense. That few can do it well enough to benefit from the exercise is obvious. That no one can pick the best fund mangers in advance of their establishing a public record is nonsense. That few can do it well enough to benefit from the exercise is obvious. That no one can use technical analysis, or fundamental analysis, or quantitative analysis, or market timing well enough to benefit from any or all of those disciplines is nonsense. That few can do it well enough to benefit is obvious.

But now you MPT guys are saying that you have a method of identifying the “best markets” and that investors can benefit from the picks that you make? What special insights, tools, or techniques are you using that aren't already being used to pick stocks, or effective money mangers, or to time markets? You're using the same back-testing techniques as they are to predict what you hope will be forward-performance, but you say that no one can do back-testing well enough to benefit from it? And you see no contradiction in that claim?

If that isn't a QED demolition of MPT I don't know what is. That crowd is ignorant of market history, and they are sloppy logicians. Plus, not a one of them can trade, which is why they persistently blow up their accounts when someone is gullible enough to entrust them with money.

There is serious money to be made using asset-class investing, however imperfect a theory it is, just as there is serious money to be made using any investing or trading approach, provided these questions are answered: WHAT? WHEN? HOW MUCH? Asset-class investing attempts to answer those three questions, just as every investing or trading approach attempts to answer them. To the extent that such approaches are based on genuine insights the behavior of markets and to the extent that risks are responsibly managed, a would-be investor or trader has a chance to make a few bucks, or even a lot of bucks. To the extent that a gambling system –-which is what asset-class investing is, which is what any investing or trading method is, an attempt to make bets on the basis of estimated probabilities-- is wrapped in beliefs which can be easily falsified is likely to be the extent to which the system proves to be worthless or harmful going forward. I can't prove that claim. But I do believe that, on average and over the long haul, good-enough results can be obtained by good-enough methods, and that in the short run, even truly awful methods can be produce excellent results out of sheer, dumb luck, which is also the reason why every method will ultimately fail. The element of randomness, the as-yet unseen “Black Swan”, will appear.

Wall Street and its academic shills exist to make money for Wall Street. Their concern is to provide profits for themselves, not truths for the masses. Wide-spread, widely-believed theories simply make easier the task of fleecing the sheep. Those sheep –-dumb money-- do serve an important function. They enable smart investors to profit from them. So count the sheep, and gather the wool, but watch out for Black Swans. Soon enough they will make hash out of MPT, and of all of us.

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